Saturday, August 19, 2006

Hedge Fund Activism, Corporate Governance, and D & O Risk

Along with the burgeoning growth of the hedge fund industry has come the increasing importance and influence of activist hedge funds. This activism has taken a variety of forms, from public pressure on portfolio companies to change business strategy, to the running of a proxy contest to gain seats on the boards of directors of portfolio companies, to litigation against present or former managers.

This increase in hedge fund activism has attracted sharp criticism. Martin Lipton of the Wachtell Lipton law firm lists "attacks by activist hedge funds" as the number one key issue for directors. He has issued a series of client memos (here, here, and here) advising companies how to prepare to fend off hedge fund attacks. He characterizes the activist hedge funds as "self-seeking, short-term speculators looking for a quick profit at the expense of the company and its long-term value." Lipton has been a vociferous advocate for greater regulatory supervision of hedge funds.

A July 2006 research paper (here) written by New York University law professor Marcel Kahan and University of Pennsylvania law professor Edward Rock, entitled "Hedge Funds in Corporate Governance and Control," takes a comprehensive look at hedge funds’ impact on corporate governance. The article is replete with specific, heavily-footnoted examples of activist hedge funds’ corporate governance activities. In general, the authors regard activist hedge funds’ role in corporate governance as positive, and one that hedge funds are favorable position to play because of their investment approach and freedom from regulatory oversight. One particularly colorful example the authors examine involves Third Point LLC’s criticism of Star Gas’s CEO Irik Sevin, to whom Third Point wrote:

It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites….We wonder under what theory of corporate governance does one’s mom sit on a Company board. Should you be found derelict in the performance of your executives duties, as we believe is the case, we do not believe your mom is the right person to fire you from your job.

Bowing to Third Point’s pressure, Sevin resigned one month later.


While the authors contend that hedge funds have unique incentives and advantages that better position them (compared to other institutional investors) to address corporate governance issues, they do acknowledge that activist hedge funds’ actions can raise certain concerns. First, hedge funds’ interests can diverge from those of fellow shareholders, as, for example when a hedge fund is a potential buyer of a company in which it has a stake. Second, with billions of dollars of assets, hedge funds put stress on existing corporate governance structures, as, for example, when loose hedge-fund coalitions target a shareholder vote. The authors acknowledge these concerns, but find them no worse than concerns surrounding other institutional investors, and argue that these concerns are not sufficient to justify greater hedge fund regulation.

The most serious criticism of hedge fund activism, the one Marty Lipton raised, is that hedge funds exacerbate short-termism. The authors argue that the market will enforce adaptive approaches to deal with the potential negative effects of hedge fund short-termism. The authors cite Lipton’s own "Hedge Fund Attack Response Checklist" as an example of just such an adaptive device, about which the authors state:

[Lipton’s suggestions] are terrific ideas, not just to deal with activist hedge funds but in general. If companies follow Lipton’s advice, hedge funds will have already made significant positive contributions to the management of U.S. companies. Moreover, if hedge funds can succeed despite companies taking these measures, we think chances are reasonably high that they have a good point.

The authors’ conclusion is that "market forces and adaptive devices take by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation."


The increasing influence of activist hedge funds has important implications for D & O risk. Specifically, activist hedge funds’ corporate governance activities can involve litigation, including litigation directed against directors and officers. A prominent recent example is Cardinal Value Equity Funds’ litigation campaign involving Hollinger International and allegations of Conrad Black’s self-dealing and other transactions, which culminated in a derivative lawsuit for breach of fiduciary duty against Hollinger’s board of directors. After an independent Board committee investigation, Cardinal negotiated a $50 million settlement with the directors not directly implicated in the self-dealing. The settlement was funded by Hollinger's D & O insurers. (Hollinger's press release may be found here. )


Hedge funds have even sought appointment as lead plaintiffs in securities fraud lawsuits. Indeed hedge funds often are the investors with the largest losses, but because they often engage in short-selling, they may be subject to unique "reliance" issues and therefore many not be "adequate" class representatives. For that reason, courts have often, though not uniformly, rejected the appointment of hedge funds as lead plaintiffs.


But because activist hedge funds view litigation as an essential part of their activist strategy, the role of hedge funds as "the prime corporate governance and control activists" has very important implications for D & O risk. While hedge funds’ activism potentially could contribute to improved corporate governance, the willingness of hedge funds to achieve their goals through litigation against directors and officers represents a dangerous variation of D & O exposure. Marty Lipton may not have been far off the mark when he described the threat of activist hedge funds as the most important issue for corporate officials.

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